P&C Insurance Economics 103.1: P&C Insurance, inflation and higher rates

P&C and especially Auto insurance companies’ earnings get pressured by higher combined ratios driven by claims inflation. As some central banks raise interest rates to tackle inflation forward investment returns support earnings and returns on equity. Higher investment income might increase competition and pressure underwriting margins further.  …

This is not investment advice. Please read the disclaimer. I might own discussed stock(s) currently or at a later time. I might transact in any securities at any time.

(see other Insurance Economics posts)

You find the pdf here.

P&C insurers are semi-cyclical businesses. Or at least, that is my view. Most consumers will not cancel their auto insurance, some businesses might have less demand for insurance (less cars on the road). Public services might be more stable than commercial business in a recession. And, with WFH quite a few office workers might indeed be able to reduce mileage — and if using telematics their premiums — in a recessionary downturn and/or when gasoline prices rise.  

Inflation might increase CR ratios and pressure underwriting profitability. We have seen this strongly in the US where used-car prices skyrocketed.  

Higher interest rates should increase investment returns going forward, but could on the negative side increase competition and result in higher industry wide CR ratios for longer, esp. in longer-tail insurance business (float becoming more valuable). Underwriting discipline is important and I believe the mentioned three companies live UW discipline.  

Insurers with the highest investments relative to premiums might see the most favorable effect on returns (on average!). In addition, sticking to disciplined companies not chasing (unprofitable) growth might be more important then ever.  

Reading Damodaran again — I tend to read Damodaran during market downturns or market volatily in industry lingo — his Little Book of Valuation motivated me to view my* insurance companies through a normalized E/P, P/B, ROE, etc. lens. The normalization includes my believe for a good chance (>>50%) that these companies will not experience severe CR pressure for too long (>3yrs). Most of them, I believe, should be able to earn solid UW margins (>4%) in the next few years.  
(*the book The Money Game should make us vary to think of our investments to be special and our personal discoveries) 

Protector seems the best option here based on the below numbers (valuation and (normalized) fundamentals). Where might the three initial formulas and metrics be wrong?  

Progressive will very likely earn higher underwriting margins (1-CR) in the longer term average again. At least I feel quite sure about it. First, the biggest segment car insurance might take a while for premiums catching up with claims inflation (the strong USD might help here). Second, it’s very profitable commercial segment grows above the firm’s average (of course a recession might reverse course). Third, i believe they will pull the right levers for getting home insurance to profitability. If growth will eventually slow down, PGR might invest less conservative and slightly increase its ROI. 

Protector is more volatile. Thus, any compounding in value might see some interruption — and potentially offer the time to buy more shares — resulting in somewhat lower CAGRs. And geometric means is what really counts in the long run for value creation. In addition to the operational risk, there is somewhat higher disruption risk.  

Qualitas is severely over capitalized as written here. This should lead to high near term payouts (divi+SBB) but longer term if business grows and capital requirements do catch up with equity levels Q’s ROEs and sustainable growth rates would pick up. I foresee this as the plausible if not probable scenario (Mexican health care and international car insurance subsidiaries). The mental experiment of Qualitas paying out today half its capital (10bn) would result in the following (blue) numbers: a P/B of 2.5x instead of 1.8x, and a much higher ROE of 32% instead of 19%, which might be much closer to the underlying operating economics. The shown returns for Qualitas are denominated in MXN, and accordingly some inflation and depreciation against USD, or EUR can be expected, ie 5% annually. 
 

Of course I could be wrong here, and underwrtiting margins of the three companies might be pressured (even go negative). Firms might even lose money from investments with the wron actions (ie defaulting credit in Europe). So far, I like to bet against that and have about 20% of my portfolio ‘at stake’.  

(there are some other cost items like interest expenses but in hte bigger picture these are not that important, as some income from fees) 
(data was from July 13, 2022)